Europe Central Bank keeps rate steady

CBS.MarketWatch.com

LONDON (CBS.MW) -- The European Central Bank's president Wim Duisenberg learned his lessons well from his mentors at Germany's central bank, the Bundesbank; he's proving to be as intractable as they ever were.

On Thursday, he declined yet again to bow to outside pressure and cut the eurozone interest rates from 3 percent. The ECB left the repo rate unchanged.

The Germans couldn't be less happy with their pupil. Over the past several weeks, the outspoken German finance minister Oskar Lafontaine has been hounding the ECB to cut rates and kick-start growth in the eurozone. Thursday was just one of the reasons why. Germany's fourth-quarter gross domestic product fell 0.4 percent from the third quarter, compounding the ever-bleaker market view of the German economy.

"I don't think the rest of the eurozone needs it [a rate cut], but Germany is so much weaker. So I'm not surprised that Lafontaine has pushed," said Sharon Coombs, European equity strategist at HSBC Securities.

There is still widespread disagreement among economists, politicians and sundry others about whether or not the ECB really should cut rates. There are those who argue that the ECB is imperiling the growth prospects by leaving the rates unchanged.

Nick Parsons, currency strategist at Paribas Capital Markets, argues that the ECB would give the eurozone a "huge psychological boost" if it cut rates. He things the bank is shirking its job, which is to help "underwrite" growth in the region. As it is, his firm estimates that the eurozone GDP grew just 0.2 percent in the fourth quarter. Things could get worse if the ECB doesn't act, he suggested.

The ECB clearly disagrees, and Parsons knows it. "They believe a slowdown in Europe is temporary and that a cut in rates would merely steepen the yield curve," Parsons said. Others say the ECB is also worried about weakening an already very weak euro. Over the past few days it has fallen to one new low after another. The currency's fortunes have taken many by surprise, and has led to a rerating of its prospects.

Goldman Sachs, for instance, on Wednesday cut its three-month forecast against the dollar to $1.09 from $1.17 because the investment bank believes the U.S. economy still has a lot of kick to it while Europe has slowed.

Observers, meanwhile, say that this could be a key testing time for the ECB as it straddles the economic needs of 11 countries. "The point about having a common monetary policy is that you can't respond to regional disturbances," said professor Stephen Regan, a European specialist at Cranfield Business School of Management.

For now, then, Germany will just have to tough it out. And by the looks of things, the government will have its hands full. Not only is it fretting about GDP growth and union demands for higher pay, but it now also has a potential corporate revolt on its hands.

On Thursday, Germany's lower house of parliament approved a bill to cut personal income tax rates and close loopholes for businesses. The move would be a boon to consumers, but could add more than 10 billion marks to the annual tax bills of corporates starting next year. Alliance AG, Europe's number one insurer, and RWE AG, Germany's second-biggest utility have already threatened to move their business out of the country.

All of this hasn't been helping German equities, which have fallen roughly 6 percent since the beginning of the year. "In the past you would have been better investing in the DAX [then elsewhere in Europe]. But now, we're remaining underweight in Germany," Coombs said.

Lafontaine, meanwhile, may well continue to petition the ECB for a rate cut. But many say such obdurance will only harden Duisenberg's resolve to hold tight on policy -- especially as the ECB doesn't seem particularly worried about other countries in the eurozone just yet.

Maybe it would help if Lafontaine remembered, then, a small piece of advise thrown out by the ECB president at Christmas about what happens when eurozone politicians pester too persistently.

It's sort of like making butter -- the more you stir the substance the further away you get from making the actual butter. Put in Duisenberg's words: "The more you beat us the more like cream we get."

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